The invention is generally directed to a system for mitigating the credit risk associated with a paired swap and in minimizing the collateral requirements of swap counterparties. The invention is generally directed to the area of commodity trading, in which parties enter into forward contracts for delivery or sale of goods at some time in the future, and hedge these forward contracts with commodity swaps. Parties enter into commodity swaps for various reasons, including hedging supply or demand, speculation, leveling of costs or markets for future production or purchases and other specialized reasons. However, major participants in the commodities market tend to assure that the counterparty with whom they are dealing will be able to either pay for or deliver the performance required under the forward contract when due. Failure of a counterparty to a forward contract to perform eviscerates the value of the forward contract for any of its purposes. Accordingly, there is a need for a system that can be used by counterparties to forward contracts to mitigate the risk of market losses in the event of credit defaults by counterparties.
Generally, market participants who act as counterparties to forward contracts have or try to obtain protection or insurance securing the performance of their counterparties.
There is a paired commodity swap credit risk mitigation system in which a central swap counterparty, known as the “Swap Entity”, enters into offsetting swaps with equivalent terms, with two swap counterparties simultaneously, thereby replacing the credit of the individual swap counterparties with the credit of the Swap Entity for amounts related to settlement payments and termination payments. Generally, if the Swap Entity is to maintain high credit quality, it must be structured such that it can balance its book in the event of default of one of the paired swap counterparties. Generally, a counterparty must collateralize its participation in the paired swap arrangement for each transaction so that the Swap Entity will have sufficient funds to balance its book in the event of default by such counterparty at any point. However, counterparties may, over time, enter into additional swap transactions in which there is a cancelling swap. Accordingly, there is a need for an improved method and system for minimizing the collateral required from participants in a paired swap credit mitigation system.
There is also a need for an improved method and system of updating and minimizing the collateral required from a participant in the paired swap credit mitigation system and procedures to enable the Swap Entity to maintain a balanced book of swaps with the various swap counterparties while enhancing the swap counterparty's possibility of receiving desired performance, either through settlement payments, termination payments or performance.
In addition, many of the paired swap contracts are designed to hedge forward contracts for performance over a period of time, such as in power contracts or natural gas contracts, where anticipated performance extends over a period of weeks or a month. Generally, once the forward contract is activated into a physical contract for delivery of the commodity, the substantial financial risks associated with performance are historically unsecured and large exposures are available to either party in the event of a financial or performance default by one of the counterparties. Accordingly, there is a need to provide a system for transferring the risk of performance and payments under a physical contract during delivery and to assure that payments are made on an ongoing basis and security is maintained so that exposure of the parties to default by the other party is reduced commensurate with performance.